Stay-at-homes will put paid to housing boom

UK house prices are going through the roof again, the fourth boom in 30 years. Close to £90bn of new mortgage lending was undertaken in the first half of this year, up more than a third on the previous year. While the biggest growth was in remortgaging to fund other consumption, house purchases accounted for £50bn of this, up nearly a third on the year.

The number of properties exchanged in April and May was 18% up, and borrowers are paying an average of 20% more for their houses than they did a year ago, the highest rate since before the collapse of 1990.

What is surprising is that this acceleration in house prices has occurred just as the economy is stalling. If Britain is not technically in recession, then the context is at least one of stagnant domestic growth and an uncertain trading environment.

The boom is, again, a southern England phenomenon with prices rippling out from London. At the regional extreme are London house prices valued at an average of five times London incomes, compared with four over the previous 30 years and close to the peak six times reached in 1988. This is well above what can be afforded by most London first-time buyers. By contrast, Scotland's house prices remain close to three times most Scottish incomes, much the same as in 1988.

Evidence from elsewhere, especially the US, is that regional house prices are mainly driven by regional incomes and housing market imbalances. British evidence is that, while regional house price to income ratios show much more volatility and divergence between regions, ultimately they display reversion to trend, the trend being set by the long run balance of regional labour market and commercial property forces.

Nothing particularly fundamental has happened in the economy in the past year. Inflation has stayed as low as anticipated, the growth performance this year has been as modest as expected and delivered regional employment growth much in line with what was expected.

The finger has been pointed at lower interest rates as the driver for the current surge, both on short-term "affordability" grounds and more subtly on long-term, asset valuation grounds. The recent contention that lower interest rates will generate permanently higher house values because of asset revaluation seems to ignore the general effect of low inflation. On these grounds, the Scots would also be seeing their house prices increase relative to incomes because they face the same interest rate and inflation regime as the rest of the UK.

In the US, where regional incomes are highly efficient predictors of regional house prices, the regional ratios have been stable through all interest and inflation rate changes.

It is true that short-term "fundability" of mortgages is easier for households facing lower nominal interest rates. But the argument that low nominal interest rates help to make house purchase more "affordable" in the long term is also quite misleading. At best, the benefit for borrowers is that volatility of interest rates is reduced.

Real interest rates remain the measure of the future cost of borrowing. As low inflation brings lower nominal interest rates, it also lowers the growth of nominal wages and dividends. So repayments will be higher than in the past because mortgage debt is not eroded by inflation. There is no free lunch here.

Part of the explanation of the recent surge is the move out of equities, which have been sliding since August 2000. Part is the lower than expected real interest rates of the past year, which have brought forward household consumption. A significant part will reflect the continuing imbalances in housing supply in the south which need to be addressed by regional planners. The bulk, however, is "irrational exuberance".

For British households, home ownership in the past has given high real returns, but these have mainly been boosted by windfall gains from inflation. The latest escalation in house prices above income growth will prove as unsustainable as those of previous booms.

But, in the absence of a trigger for a sharp correction, a long stagnation of housing market activity is in prospect as households lock into their housing assets and resist the return to fundamental values.

· Saxon Brettell is a director of Cambridge Econometrics